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1 Market structure II- Other types of imperfect competition OTHER TYPES OF IMPERFECT COMPETITION Characteristics of Monopolistic Competition Monopolistic competition is a market structure in which many firms sell products that are similar but not identical Characteristics Many sellers Product differentiation Free entry What Is Monopolistic Competition? Product Differentiation A firm in monopolistic competition practices product differentiation if the firm makes a product that is slightly different from the products of competing firms. 1

2 Monopolistic Competition Many Sellers The presence of a large number of firms in the market implies: Each firm has only a small market share and therefore has limited market power to influence the price of its product. Each firm is sensitive to the average market price, but no firm pays attention to the actions of others. So no one firm s actions directly affect the actions of others. Collusion, or conspiring to fix prices, is impossible. Monopolistic Competition Entry and Exit There are no barriers to entry in monopolistic competition, so firms cannot make an economic profit in the long run. Examples of markets which have characteristics of monopolistic competition Restaurants Computer games Hotel accommodation Beauty consultants Opticians 2

3 The Monopolistically Competitive Firm in the Short Run The firm in panel (a) makes a profit because, at this quantity, price is above ATC The firm in panel (b) makes losses because, at this quantity, price is less than ATC The Long-Run Equilibrium When firms are making profits new firms have an incentive to enter the market Supply increases Prices fall Existing firms wanting to sell more must reduce prices Close substitutes means effectively the demand curve for an individual firm shifts to the left Firms making loses will exit market Supplies fall and prices rise Process continues until zero profits are made Long-Run Monopolistic Competition $ Long Run Equilibrium (P = AC, so zero profits) MC AC P* P 1 Entry D Q 1 Q* MR MR 1 D 1 Quantity of Brand X 3

4 Price and Output in Monopolistic Competition Long Run: Zero Economic Profit In the long run, economic profit induces entry. And entry continues as long as firms in the industry earn an economic profit as long as (P > ATC). In the long run, a firm in monopolistic competition maximises its profit by producing the quantity at which its marginal revenue equals its marginal cost, MR = MC. Monopolistic vs. Perfect Competition Panel (a) shows the long-run equilibrium in a monopolistically competitive market Panel (b) shows the long-run equilibrium in a perfectly competitive market Only the perfectly competitive firm produces at the efficient scale Price equals marginal cost under perfect competition, but price is above marginal cost under monopolistic competition so exerting market power Monopolistic competition uses of advertising and tries to establish a brand Price and Output in Monopolistic Competition Monopolistic Competition and Perfect Competition Two key differences between monopolistic competition and perfect competition are: Excess capacity Markup A firm has excess capacity if it produces less than the quantity at which ATC is a minimum. A firm s markup is the amount by which its price exceeds its marginal cost. 4

5 Price and Output in Monopolistic Competition Making the Relevant Comparison The markup that drives a gap between price and marginal cost arises from product differentiation. People value product variety, but product variety is costly. Monopoly, monopolistic competition and perfect competition A monopoly firm, in contrast, can earn persistent profits provided that source of monopoly power is not eliminated. A monopolistically competitive firm can earn profits in the short run, but entry by competing brands will erode these profits over time. Oligopoly Oligopoly is where competition is between a few Duopoly is an oligopoly with just two members Competition, Monopolies and Cartels Groups of firms might decide to behave like a monopoly by agreeing between them what to charge or what quantities to produce. They are colluding The group of firms colluding is a cartel 5

6 Game Theory Framework Overview of Games and Strategic Thinking Game theory is the study of how people behave in strategic situations. Games consist of the following components: Players or agents who make decisions. Planned actions of players, called strategies. Payoff of players under different strategy scenarios. Simultaneous-Move, One-Shot Games One-Shot Games: Theory Strategy A decision rule that describes the actions a player will take at each decision point. Dominant strategy A strategy that is best for a player regardless of the strategies chosen by the other players. Normal-Form Game Set of players Player B s strategies Player A Player B Strategy Left Right Up 10, 20 15, 8 Down -10, 7 10, 10 Player B s possible payoffs from strategy right Player A s strategies Player A s possible payoffs from strategy down 6

7 The Prisoners Dilemma The Prisoners dilemma is a game between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial In this game between two criminals suspected of committing a crime The sentence that each receives depends both on his decision whether to confess or remain silent and on the decision made by the other. A dominant strategy if it is the best strategy for a player to follow regardless of the strategies pursued by other player Both Mr. Green and Mr. Blue confess and both spend 8 years in jail If they had both remained silent, both of them would have been better off The Equilibrium for an Oligopoly Competition laws prohibit explicit agreements among oligopolists A Nash equilibrium is a situation in which oligopolies choose their best strategy given the strategies the others have chosen Oligopolies would be better off cooperating Instead oligopolies choose self interest at the expense of maximizing joint profit Oligopolies as a Prisoner s Dilemma Consider an oligopoly with two firms, BP and Shell. Both firms refine crude oil Both firms agree to keep refined oil production low in order to keep the world price of refined oil high They must now decide to stick to the agreement or ignore it The profit that each earns depends on both its production decision and the production decision of the other oligopolist The dominant strategy is for both to ignore the agreement and go for high production This is an inferior outcome than if both stuck to the agreement The dilemma also applies to advertising and common resources 7

8 Games in Economics Repeated Game: game is played repeatedly over a period of time In a perpetual repeated game, equilibria that are not stable may become stable due to the threat of retaliation. Restraint of Trade & Competition Law Designed to discourage collusion Controversies over Competition Policy Resale Price Maintenance A business may wish to protect brand image of which a high price is part of its marketing strategy Predatory Pricing Where is the boundary between predatory and competitive pricing? Tying Where a customer is required to buy something they do not want as a condition of buying something they do want 8

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